Earlier this week, the Second Circuit held that an auditor has a duty to correct its prior certified opinions, and may be held liable under § 10(b) and Rule 10b-5 if it fails to do so. The opinion appears to be the first in the Second Circuit to squarely hold that an accountant has such a duty or may be primarily liable under the federal securities laws.

A copy of the opinion in Overton v. Todman & Co., CPAs, P.C., is available from the Second Circuit, here, or from FindLaw (reg. req'd), here.

The opinion reverses a lower court decision dismissing a securities fraud claim against the auditor, and its successor in interest, Trien, Rosenberg, Rosenberg, Weinberg, Ciullo & Fazzari, LLP.

From 1999 through 2002, Todman audited the financial statements of Direct Brokerage, Inc. (“DBI”), a broker-dealer registered with the Securities and Exchange Commission and a member firm of the New York Stock Exchange. Each year, Todman issued its “unqualified” opinion that DBI’s financial statements accurately portrayed the company’s fiscal health.

Despite its certifications of accuracy, Todman was alleged to have made significant errors that concealed DBI’s largest liability, payroll taxes. The plaintiffs alleged that Todman ignored multiple red flags that cast serious doubt on the accuracy of DBI’s financial statements, and alleged a number of facts in support of their assertion that Todman recklessly audited DBI’s affairs and recklessly evaluated whether DBI could “survive as an ongoing concern.” Plaintiffs alleged that, in 2003, DBI’s payroll tax liability led to the broker-dealer’s collapse.

The Court surveyed its prior law on primary accountant liability and concluded:

that for many years we have recognized the existence of an accountant’s duty to correct its certified opinions, but never squarely held that such a duty exists for the purposes of primary liability under § 10(b) of the 1934 Act and Rule 10b-5. Presented with an opportunity to do so, we now so hold.

The Court held that the District Court erred in dismissing the fraud claim against Todman & Co., and that an auditor may have primary liability under § 10(b) and Rule 10b-5 for a failure to correct a prior audit opinion, when the accountant:

(1) makes a statement in its certified opinion that is false or misleading when made;
(2) subsequently learns or was reckless in not learning that the earlier statement was false or misleading;
(3) knows or should know that potential investors are relying on the opinion and financial statements; yet
(4) fails to take reasonable steps to correct or withdraw its opinion and/or the financial statements; and
(5) all the other requirements for liability are satisfied.

The Court went on to note two limits to the holding.

First, the Court held:

that an accountant has a duty [only] to correct its prior certified statements, as opposed to a broader duty to update those statements. The duty to correct requires only that the accountant correct statements that were false when made. In contrast, the duty to update requires an accountant to correct a statement made misleading by intervening events, even if the statement was true when made.

Second, the Court noted:

that an accountant need correct only those particular statements set forth in its opinion and/or the certified financial statements. Unless an accountant exchanges its role for the role of an insider an accountant is under no duty to divulge information collateral to the statements of accuracy and financial fact set forth in its opinion and the certified financial statements, respectively.

The Court was clear to note that the Todman holding did not conflict with Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994), which held that there was no aiding and abetting liability under § 10(b), as the auditor in this litigation had acted as a speaker in a primary capacity.

February 22, 2007

Options Backdating List Update

Our options backdating securities class action list has been updated to add Openwave Systems Inc. (NASDAQ: OPWV). The number of companies on the list now stands at 26.

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February 21, 2007

A Fourth Circuit Judge Did What?

First, the non-newsworthy part.

Yesterday, the United States Court of Appeals for the Fourth Circuit affirmed the dismissal of the consolidated securities class action pending against Cree, Inc. (NASDAQ: CREE), and six of the corporation's officers and directors. A copy of the Fourth Circuit's opinion is available here.

The dismissal itself (and certainly the affirmance by the Fourth Circuit) is not the big news. A quick review of the SCAS database reveals that fully 50% of the federal securities class actions filed within the Fourth Circuit since the PSLRA was enacted have been dismissed.

The big news is the dissent in the Cree litigation, authored by Judge Dennis W. Shedd.

Judge Shedd takes issue with the scienter analysis performed by both the District Court and the majority. In his words:

The majority approach to testing the adequacy of the Complaint examines in isolation each individual suspect transaction in order to ascertain whether the elements of securities fraud have been adequately pled with respect to each one. However, this approach ignores the fact that this case revolves around a single securities fraud action against a single company, Cree.

Judge Shedd goes on to write:

the Complaint does not-and need not-allege an action for securities fraud with respect to all six companies with which Cree dealt. Instead, the Complaint alleges a single cause of action for securities fraud, as evidenced by many transactions with multiple companies. If even one of these transactions is pled adequately enough to meet the pleading requirements under the PSLRA and Rules 8 and 9, the cause of action must survive the motion to dismiss. Moreover, if the totality of Cree's actions reveals a larger picture of fraud sufficient to meet the necessary pleading requirements, this case must advance beyond the current stage of the proceedings

Judge Shedd also takes issue with the analysis adopted by the majority regarding the standards to be applied to so-called "confidential sources." Such information sources, typically former employees or customers of the corporate defendant are a common investigative and pleading technique used by plaintiffs to meet the pleading standard imposed by the PSLRA.

The majority adopted the standard employed by the Seventh and Second Circuits in Makor Issues & Rights, Ltd. v. Tellabs, Inc., 437 F.3d 588 (7th Cir.2006) and Novak v. Kasaks, 216 F.3d 300 (2d Cir.2000), respectively. Under that analysis, a complaint which relies on confidential sources must allege facts sufficient "to support the probability that a person in the position occupied by the source would possess the information alleged."

Judge Shedd, in his dissent disagrees with the adoption of the Tellabs/Novak standard, noting:

I would resolve the issues surrounding unnamed sources differently because the approach adopted by the majority does not inhere in the plain language of the PSLRA. The plain language of the PSLRA does not subject unnamed sources to higher scrutiny than other averments made upon information and belief. Accordingly, in my view, a complaint must simply identify unnamed sources "with particularity," as required by the plain language of the PSLRA, which might include the source's job title and years of employment, or possibly, other facts sufficient to support a reasonable belief that the plaintiff did not merely invent sources. The purpose of the PSLRA's particularity requirement is to prevent the fabrication of information, not to weigh its reliability or credibility.

The Teachers' Retirement System of Louisiana is the lead plaintiff and Grant & Eisenhofer, P.A. are lead counsel in the Cree litigation.

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February 20, 2007

Options Backdating Securities Class Actions: The List - Update

Time to catch up on some housekeeping matters that resulted from the recent dormancy of Securities Litigation Watch.

The first order of business - our options backdating securities class action list has been updated to add Amkor Technology (NASDAQ: AMKR), Apollo Group (NASDAQ: APOL), Hansen Natural Corporation (NASDAQ: HANS), Quest Software (NASDAQ: QSFT) and Sunrise Senior Living (NYSE: SRZ). The number of companies on the list now stands at 25.

We will continue to update and maintain this list to track all newly filed securities class actions that have options backdating related allegations. The list will also include any previously filed cases that have recently added options backdating allegations.

Another excellent resource is The D&O Diary's list of options backdating related derivative lawsuits, here.

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February 13, 2007

A Gentle Rebuttal to Prof. Grudfest

Last week, in a widely-circulated and much discussed Wall Street Journal op-ed column entitled “The Class Action Market” (here, sub. req'd), former SEC Commissioner and current Stanford Law Professor Joseph Grundfest suggested that private securities class actions have lost their utility in policing the securities markets and compensating investors.

I respectfully disagree with Prof Grundfest.

And so, apparently do the Department of Justice and the Securities and Exchange Commission.

In a little noticed amicus brief filed last Friday by the DOJ and the SEC in the Tellabs, Inc. v. Makor Issues & Rights, Ltd. appeal before the U.S. Supreme Court, the federal regulators noted:

Meritorious private actions are an essential supplement to criminal prosecutions and civil enforcement actions brought, respectively, by DOJ and the SEC.

Prof. Grudfest also suggests that private securities litigation is "virtually useless as means of compensating investors for their losses."

Investors in AOL or Time Warner securities would also probably disagree with Prof. Grundfest.

The private securities class actions involving AOL Time Warner settled for $2.5 billion. Time Warner settled with the federal regulators for a small fraction of that amount - $150 million to the Department of Justice and $300 million to the United States Securities and Exchange Commission. While the combined $450 million in federal regulatory settlements is not chicken feed, it is only 18% of the amount recovered in the private class action.

And the AOL case represents two of the largest payments ever made by a corporate defendant to the federal government to settle securities fraud related allegations. In many private cases, there are no state or federal penalties or disgorgements to compensate investors. For example, in the Williams Securities Litigation:

1. The company had not restated their financial statements.
2. No governmental investigation had uncovered any fraud.
3. No employees of the corporate defendants had been fired
4. Defendants never acknowledged that any improper conduct had occurred.

Yet the private securities class litigation was able to recover a substantial sum for investors, settling in 2006 for $311 million.

Expect more chatter on Prof. Grundfest's proposal during the next few months.

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February 12, 2007

Does a Serial Recidivist = Corporate Scienter?

If a company engages in two separate alleged securities frauds six years apart, with an intervening bankruptcy reorganization but retains at least six officers or directors from the predecessor entities, is it possible that the prior allegations could be used to bolster the corporate scienter allegations in the new litigation?

Sounds a little complicated, so let's break it down.

Way back in February 2001, Globalstar, L.P., Globalstar Capital Corporation and Globalstar Telecommunications Limited (collectively "Old Globalstar") were accused of making false and misleading statements regarding Globalstar’s financial prospects and condition. That case culminated in one of those ultra-rare securities class action trials, and ultimately settled for $20 million.

After the complaints in the first case were filed, but before that case went to trial, all of the Old Globalstar entities filed for bankruptcy protection.

Fast forward to 2007.

The Globalstar entities have reorganized as Globalstar, Inc. (NASDAQ: GSAT), filed a registration statement for a new IPO, and, as of last week, been hit with a fresh group of securities class actions.

How then do allegations of serial recidivism help to establish the scienter of a defendant corporation?

There are at least three distinct tests for corporate scienter, including two versions of the "collective scienter" theory being applied by the courts today.

Under the collective scienter theory, the analysis is based on the collective knowledge of the corporation's employees.

Under the stronger version of the collective scienter theory, a plaintiff can establish that the corporation acted with fraudulent intent without any reference to a particular employee. See, e.g. In re Dynex Capital, Inc. Sec. Litig., 2006 WL 1517580 (S.D.N.Y. June 2, 2006).

Under the weaker version of the collective scienter theory, a plaintiff need only establish that a management-level employee of the corporation acted with the requisite fraudulent intent, even if that employee is not a defendant and did not make any alleged false statement. See, e.g. In re Sonus Networks, Inc. Sec. Litig., 2006 WL 1308165 (D. Mass. May 10, 2006); In re Marsh & McLennan Companies, Inc. Sec. Litig., 2006 WL 2057194 (S.D.N.Y. July 20, 2006).

At the far end of the spectrum, and seemingly losing support by the day, is the concept that the corporate scienter analysis could only be determined by looking:

to the state of mind of the individual corporate official or officials who make or issue the statement . . . rather than generally to the collective knowledge of all the corporation's officers and employees acquired in the course of their employment.

Southland Sec. Corp. v. INSpire Ins. Solutions, Inc., 365 F.3d 353 (5th Cir. 2004).

While the new Globalstar cases have just been filed, the overlap of six senior officers or directors between the old and new entities (none of whom are currently named as defendants in the new litigation) may provide an interesting test case for the limits of the collective scienter theory.

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February 11, 2007

Welcome Back

Welcome to the new, freshly updated Securities Litigation Watch.

I am your new host, Adam Savett, and I'm the Vice President, Product & Market Segment Manager for Securities
Class Action Services at ISS.

A number of you may have read my musings on securities litigation at my old blog, Lies, Damn Lies, & Forward Looking Statements.

For those that are not readers of my old blog, or former colleagues, I'll take a brief moment to introduce myself.

I am a recovering attorney, having spent the past six years as a practicing securities litigator at firms in Philadelphia and Washington, D.C. During that time I represented and advised institutional investors, including public and private pension funds as well as Taft-Hartley plans, in all aspects of securities litigation, and had primary day-to-day responsibility for my firm’s institutional investor portfolio monitoring programs.

Now I manage the suite of Securities Class Action Services products for ISS. These products make ISS the only firm that delivers a complete, outsourced class-action service to specifically help institutional investors meet their fiduciary responsibilities.

The purpose of this blog is to both educate and entertain as we discuss the wild and sometimes wacky world of securities litigation. Readers are strongly encouraged to send in story ideas or tips or even guest posts if a topic is near and dear to your heart.

And so, without further adieu, let the blogging begin...

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